The Market Can Stay Irrational Longer Than You Can Stay Solvent

Via Tim Fernholtz, an interesting Wall Street Journal article summarizing Richard Posner’s views on the economic crisis. I think much of what Posner says here is smart, but this is somewhere between misleading and wrong:

The conventional wisdom is that very smart bankers misunderstood their own interests. In a capitalist system, if you can’t trust self-interest, what can you trust? Judge Posner instead reminds us that shareholders would have punished individual banks that failed to take advantage of low interest rates and seemingly safe, mortgage-backed securities. Likewise, consumers acted rationally over the years to accept offers of mortgages they couldn’t afford, given the low risk of a burst bubble.

“At no stage need irrationality be posited to explain what happened,” Judge Posner writes. Instead, this was a case of “intelligent businessmen rationally responding to their environment yet by doing so creating the preconditions for a terrible crash.” He chiefly blames the Federal Reserve, for “cheap credit.”

I’ll just note as a starting point that the whole idea that one might “posit” irrationality is a powerful glimpse at the tight grasp neoclassical economics has over the public discourse. Many economic models work by positing rationality in a world that appears to be full of irrational behavior. But the models now have such a hold on our thinking, that people who suggest that sometimes things are exactly as they seem—full of irrationality—are positing something.

Beyond that, though, it’s important to make the point that for the market to exhibit irrational behavior doesn’t require individuals to be hugely loopy or anything. Keynes addressed this in Chapter 12 of the General Theory. The conventional thing for professional investors to do is to focus on trying to make money off fairly short-term market fluctuations rather than to assess the long-term prospects of investments. Of course you could try to make money by bucking that trend but:

If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

The big point here is that to make a long-term play, you may need a huge amount of capital at your disposal. And it’s going to be very hard to raise that kind of capital, because conventional wisdom will hold that you’re a crazy person. If you happen to have a vast fortune at your disposal, you can play this game. And a few people do. But there simply aren’t enough people in possession of sufficiently vast fortunes for this to work as an adequate corrective mechanism. The saying is that “the market can stay irrational longer than you can stay solvent”. Even worse, the problem gets recursive. Since everyone knows that the market can stay irrational longer than you can stay solvent, nobody can count on investors making the rational play which means the market may stay irrational a very long time.

Consequently, the market won’t act as a self-correcting mechanism and things can get badly out of control. I think the fan of free markets can fairly reply that it’s not obvious what the solution to this problem is, but I don’t think it’s tenable to deny that the problem exists.